PAUL JOHNSON: The guys that drove Cadillacs sold options. The guy that drove Chevys won options.
Somebody today asked, well, how many people think there'll be a recession next year? And nobody raised their hand.
I'll vote for you if you give me a raise. Well, heck, I'll give you a raise. What do I care?
TYLER NEVILLE: I'm Tyler Neville from Real Vision. And we're here at the EQDerivatives Conference. And I'm interviewing Paul Johnson of Illinois SURS, which is the State University Retirement System. We're going to understand how they use derivatives overlays on the pension system, and also go into a little bit of the politics about Illinois. I hope you enjoy it.
Paul Johnson here, CIO of LSE trading and former trustee of Illinois SURS, State University Retirement System.
PAUL JOHNSON: Yes. And also Chicago Educational Research Foundation. My colleagues there would be sad if we didn't mention that name somewhere, you could cut it later.
TYLER NEVILLE: Of course, no, no. I love it, love it. So, we just love to dig into your background first. And we'll go from there.
PAUL JOHNSON: Well, I come from the trading floors of Chicago. So, the derivative exchanges, CBOE, the options exchange, the Chicago Board of Trade, which now merged with the Chicago Mercantile Exchange, which I was also a member. I've had businesses down there trading in brokerage and I also used to be on the Board of Trade's Board of Directors, lead teams and wrote the Fed fund contract and rewrote the Treasury complex and things that everybody here uses and Dow Jones contracts and so on.
I've been around for a little while, tried to do a little thing, did some of the work, we went public and you'd asked about LSU earlier, and I used to wear my LSUs, because I went to Louisiana State. And I had to have an acronym. And all my initials were taken. So, I wound up with LSU. And so, for decades, people don't use LSUs sometimes on the floor, or Paul, they use RT or Paul or jerk or whatever, I'll answer to them all.
TYLER NEVILLE: We're at the EQDerivatives Conference, you advise I think a lot of big pension funds on how to manage their derivatives exposure. Could you dig into that?
PAUL JOHNSON: Sure. Well, primarily my exposure to EQ derivatives, which is a fairly new conference. And it's a great conference. But EQ derivatives takes it to the next level and comes at it with a little bit different angle. And that brought me out here, but also, as a trustee of SURS, I was concerned on ways to cut costs, increased revenue, and do things more efficiently. And they did a lot of good things. But they literally miss hundreds of millions of dollars through errors or ignorance. And maybe that sounds like a lot or little. But it happens at a lot of pension systems.
And so, what I've done and the reason I'm out this year is to walk people through the story that we had. We went from people not knowing how to use futures or options to implemented little things that added a million here and millions there, showed them how they lost $60 million at one time, they didn't even know they lost, to have them use options to rebalance their portfolio somewhat synthetically, because people understand that's part of the problem with trustees of public pension system. They don't necessarily know the markets, they teach English, bright people, they teach accounting, but they don't necessarily know investments.
And so, it's been a process in walking them through, but there's certain things that they could easily grasp and allow them to take advantage of the marketplace that we talked about here in such a way that we have a rebalancing strategy. If we could have put it in back in the day when we talked about a setting, it was a couple billion dollars that they missed- not free money, but money that they could have used their capital to gain over the years.
TYLER NEVILLE: You are a trailblazer in terms of utilizing options on the pension fund level. Are there late movers now getting into the area? And how do you see that ecosystem evolving? Are they so late to the game of the short vol overlays on their equity portions? Or are losing alpha? Or how do you see that ecosystem?
PAUL JOHNSON: Well, the last couple years have been tough for a lot of people because of the way the markets have moved in the selloff. Some guys have done okay, some guys did horribly. So, that's made it a little tougher because of the way the markets where you think, hey, it's moving, this is great, but not necessarily so. I don't think people have missed it. I think where we are in the CBOE for example, has been around what- 40 some odd years now, and some people are just finding out about it. Some people are afraid of it.
And in fact, a few years ago, the Labor Department wasn't going to let [inaudible] accounts use options because they were too dangerous. And they were asked well, as compared to what? And so, we don't know. They literally didn't know anything, so they took the rule out. But more people are using it. There's an article in The Journal a year ago in March, and they talked about 2013 and how few pension systems use them in the US. And then they talked about now, there's multiples of what they were but there're only 60 some odd pension systems using them. And most of those are the most successful that are out there.
But there're still thousands, some of them are little. Illinois has 650 police and fire pensions throughout the state that have a million here, maybe a billion there. But they're so inefficiently run and have higher costs. There's somebody that could come together. And actually, the former chairman of the CBOE was trying to put it together for the governor, to bring them all together so that they get economy of scale, they could have maybe one CIO and staff or bringing them all together, save millions a year and run things more efficiently. They could really benefit from it.
TYLER NEVILLE: What inning do you think we are in terms of transitioning all those pension funds into becoming really efficient machine?
PAUL JOHNSON: Second inning.
TYLER NEVILLE: Really? It's that early?
PAUL JOHNSON: I would equate it to a hockey stick formation. You've got so few people using it, there's still more room in the trade, especially in the large indices. Some of the individual stocks might be harder for larger funds to use. But there's still plenty of room to exchange though, which is, of course, very transparent to do it.
But to give you an idea, there's a study in Canadian pension plans, I'm trying to think of the group that- I think they're called Commonwealth out at Canada. And the reason I mentioned them, one of the better run funds is called HOOPs, the Healthcare of Ontario Pension Plan. And the difference between them and a typical pension system in the US is they have a CYA mentality, you got to cover their behind here in the States, and rightfully so.
If you're a guy, CIO, and you said, I think it would help us out if I use some of these options products and a couple things, I see where they would save us money. The thing is, if they do it, right, they don't really get much of a raise a few percentage points if they're lucky. And if it's something goes wrong, you're fired. So there's no incentive to do anything, because the disincentive is you lose your job.
Well, in Canada, people are empowered to make money, they have larger staff. And you don't necessarily have to have the staff. The guy that serves has no Doug Wesley's is a bright guy that's embraced a lot of this stuff, fortunately. But the Canadians and I use HOOP, from '07 to '17, they made 9.08% return. SURS was just above average at about 5.5%. And I said just above average over that same period of time.
Well, that's 350, 360 basis points a year over that same period. Illinois only 40% funded. If somehow we could replicate those 10 years and go on- which we know we can't, but what we know we can do is replicate a lot of that better performance, because there are more efficient ways to do things. If somehow we could do that instead of the 35 years or 40 years that Illinois wants to get to 90%, you could do it in 50.
And it's just by being smart, just if you want to buy something, buy it the most efficient way. If you want to have revenue, do something smart that gives you liquidity, and especially when you need cash. And options strategies, by and large, will give you that.
TYLER NEVILLE: That 300 basis points gap can be generated off the equity portion or do you-
PAUL JOHNSON: Overall. It's more so the fixed income products and your equity products, you can do some real good to your portfolio.
TYLER NEVILLE: So, can you talk about the breakdown? How does a pension fund break down all their investments? And what's the decision making into how much allocation of equity, how much allocation of fixed income, private equity in the breakdown of those things? How do you go about finding the managers?
PAUL JOHNSON: Well, first of all, the investment consultant is a very powerful person in the public pension world, mainly so the CIOs got cover, we blew up, it was his fault, let's fire him, we'll get a new guy. People cover their behinds and get to go on. But the asset allocation is probably the most important thing that you do. And you need to decide how your money should be. And it's funny, we did go into depth a lot of things if you went back over this last decade, if you had a simple 60-40 stocks, bonds, those actually did the best.
Some of the things that we do in the option world is either is enhance it, or free up capital so you can do something else with your money, a little bit of a lever, you don't want to over leverage, leverage is a fine thing. It just has to be used properly. I know a lot of people will be afraid of it. I've talked to trustee, oh, we can't leverage, I don't want it.
As a matter of fact, they wanted to get out of anything that has leverage in any way. They have to get out because their buddy told them this. And this is a guy that teaches English in this case. I'm like, okay. So, if leverage has evolved so bonds, it's completely leveraged. So, well, what do you mean, we'll have power and by money to leverage the United States government or corporations or who's ever debt we're buying at something. And so, you don't want to own any stocks? I say, what do you talk about? I love stocks.
Well, every stock in the S&P 500, every company has borrowed some money. They're leveraged however little to a lot. They're all leveraged. So, you want to cut out all these guys? Oh, well, maybe not. Maybe I didn't understand what he meant. But these are the guys that are making billion dollar decisions that you have to talk to explain things and first of all, says, oh, derivatives are a terrible thing.
Why are they bad? What's bad about them? Well, can't they blow up? Can't stocks go down? Is it real estate better? Or would have you been happier buying real estate in '07 and selling it in '08? And everything has a risk. And it's just you've got to be willing to take the risk and do it in a prudent and more effective manner.
And I remind them, I said even the stock you think you own is a derivative. Because if you own Apple, you really don't own Apple, it's you're custodians of Northern Trust or SURS, it actually rests on their books in the Street name. So, it's easier to transfer should you transfer it out. It's not in the customer name, there's a bookkeeping entry, but that makes it the derivative. So, you really own the stock, and you get all the full benefits. And if you didn't know that, that wouldn't affect you.
But so people get hung up on leverage or derivative. And none of those things are bad in themselves. They're bad when people make poor decisions. But if you do it very prudently, you wind up, enhance it- I mentioned the Canadian study in the comparison a year or so ago or two years ago, I look at certain things, they only owned actually some Apple stock outright, 97% of their whole portfolio was equity replacement, derivative products of one kind or another. They enhance their fixed income world and in amazing ways.
Air France is another- or excuse me, Air Canada, is another great example. They were worried about going belly up with their pension system, they decided to take some risk, use a little leverage in the fixed income, happened to catch some things right to their credit, and they went from a deficit to 110, 115- I forget what the actual number, just by doing some smart things, using your money prudently, buying something that's cheap, and selling something that's expensive.
I told a story today, we had some group of guys in educational five years ago come in to talk about hedge funds and other- just groups that come in front of the then chairman. And somebody asked, well, what about this portfolio insurance I've been here about, I was like, should we get some of that stuff? And they go, oh, you're talking about just buy and puts all that gets very expensive if you do it too long. And indeed, he's right.
And it's, yeah, so it would cost a lot of money to do this and that. And then, of course, I wanted to talk to them more about it, too. It was my early days, because I wanted to educate them. And so, well, if it's so expensive you're saying? He goes, yeah, it's way expensive. So, why don't we sell it? And so, you would have thought like, was this guy nuts? He wants to put chocolate and peanut butter together? Who does that? That'll never work.
And so, we talked and actually, this chairman say, because these guys are bright guys, they just don't know this world. There's some things that they just didn't get. If you've got a million dollars in the stock portfolio, you could either let it sit there and then the bank will use your stock to lend to somebody else and they'll take that money, you could do that. But that's pennies. Or you can have a conservative option overlay is a way to enhance something that really like the combination strategy.
And they talked about which is really the rebalancing or selling strangles, that funds will do that over time, that gets returned about 11%, that there are ups and downs. There are times they lose, there are times they win. But over the long haul, it does a little better. Use the money you have to enhance. I'm not saying doing it fully- that you fund it fully. But you don't have to do- if you got a million dollars, you don't do an X million dollars, you could do a fraction of that.
TYLER NEVILLE: When you primarily think about investing in US equity per se, are you doing that passively? Or are you doing that actively in terms of like the Illinois SURS?
PAUL JOHNSON: As far as Illinois SURS, yeah, they have a lot of equity, but they have been in a process moving about 5 billion into equity replacement strategies, so much like the combination trade, or just selling puts, which keep up for the most part with the overall market. And there'll be times when the market's moving very quickly, they fall behind. When it's not going up so quickly, they do well. And when it goes down, they do really well.
There was a February 5th- was it last year? You had the market, S&P went down, I want to say 6.3% or 4%, in one day, February 5th. And there was articles, oh, look, the market's falling apart. But they talked about this option strategies, they lost 4.3%. And of course, I looked at it like, well, that's good. I think it was 180 basis point difference, or whatever it was. I said, so, you're telling me on a day when they have equity exposure, the market got killed in one day, one of the worst days ever down, they actually did 180 basis points better. So, when you come back, because the market did come, you catch up much more quickly.
As we know as people experienced 2008, as the market dropped all the way in the March of 2009, if you could have somehow mitigated your loss and only lost 10% or 20%. But when the market starts go up, back up, guess where you're starting from? A lot higher level than this guy that's done a 50%, he's going to have to double his money just to catch up to you. And my point is those equity placement strategies, that one in particular, can help you in a big way, especially when the market goes down.
So, those firms that still have it when the market does, whether it's next year or next decade, I'm not sure, that's the big debate. When you have a pullback in the equity markets, they're not going to get hurt as badly. And depending on how it goes, they could actually make money. Because they could make money in a declining market if it's slowly declining. They will profit while your equity- for regular accounts- is going to lose money.
TYLER NEVILLE: So, you think if there's ramifications of everyone starts doing that, where it causes more, I guess, tail risk or what's the perspective on that?
PAUL JOHNSON: I think if more people come in, there'll just be more players. And there's always new rules. It used to be- until they changed some of the Dodd Frank and rules, you'd have more natural sellers of puts, well, they've gotten more expensive. So, there's room for more people, maybe them, to come back in and they might drive it down. In which case, you'd have to change your strategy. And maybe some of that would be different. And somebody would get hurt, smart money would maybe take the other side because it's not 100% trade where you're always making money. It's just you usually making money.
I used to joke on the floor, that I think the guys that drove Cadillacs sold options, the guy that drove Chevys won options, but you can make money both ways, it's just a matter of how much.